I’ll be moderating a Firedoglake book salon for: Lost Decades: The Making of America’s Debt Crisis and the Long Recovery, by Menzie Chinn, (of Econbrowser fame), and Jeffry Frieden, today, October 1st, from 5pm to 7pm Eastern Time.
It’s an online book salon, and it is free to register and leave questions in the comment section. The location for the book salon is here. Hope you can swing by and post a comment! Below is my introductory post which will go up at the site when the event begins, along with the first set of questions I’ll use to start the discussion:
What caused the housing bubble?
This is a different, though related, question from what caused the collapse of the financial sector or why unemployment is sky-high right now. Why did housing value skyrocket and then collapse? More broadly, why did all kinds of consumer debt expand so greatly over the past decade?
There are plenty of arguments out there, each with their proponents and their books. There’s the argument that the bubble is primarily the result of an out-of-control Wall Street, which was capable of getting money into housing by convincing investors that it was safe (while betting against it). There’s an argument it was the result of government policy and activism, of Community Reinvestment Acts and mortgage subsidies. There’s another approach which thinks it was the result of “irrational exuberance” on the part of homeowners, who all chased rising home prices which kept blowing air into the housing bubble.
But there’s another argument, which looks at the explosion of international lending and the indebtedness of the United States by foreign investors. Normally capital runs from rich countries to poor countries, but something changed where it reversed as capital went rushing to the United States. This exposed the United States to the same kind of risks developing nations usually face. And the new book Lost Decades by Menzie D. Chinn and Jeffry A. Frieden, economists at the University of Wisconsin, Madison and Harvard, is the best book-length treatment of this argument.
Lost Decades looks at why the explosion of debt happened through the traditional lens of supply-and-demand. It examines the motivations and situations of people on both side of this debt. Why did demand for debt increase in the United States? The first reason Chinn and Frieden identify are the huge deficits run during the George W. Bush years. These are the trillions spent on the Bush tax cuts, the expansion of Medicare part D and wars in Iraq and Afghanistan that weren’t paid for.
The second is the massive expansion of debt among private households. This was the result of “debt fever spread[ing] to the private sector.” “Americans began borrowing to supplement their incomes, in expectation of future economic growth.” This led to “debt-financed” consumption” which helped to deal with the problem of “working-class and middle-class Americans [seeing] their incomes stagnate.”
This lead to an explosion in the measure for a country’s foreign borrowing, the current account deficit. What was around $100 billion a year in the 1990s averaged $600 billion a year during 2001-2008. Nearly one-third of all the country’s home mortgage debt was owed to foreigners.
On the flip side of demand is supply. Where did all this money come from? Lost Decades looks at three major culprits on the supply side. The first is the traditional kind, wealthy individuals in an age of rocketing inequality. The second are the oil-exporting Middle East countries and their “sovereign wealth funds.” And the third are East Asian countries holding huge currency reserves, particularly China which maintained a weak currency to keep a manufacturing edge.
Why is this bad? The first reason was that the debt wasn’t going to productive uses. As the IMF pointed out, a huge rise in federal deficits, housing debt and residential construction “does not raise US productive capacity.” Second, and more important, this exposure to foreign debt puts the United States at risk of debt crisis that were familiar to people studying developing countries. The comparisons the authors draw are between the United States and 1970s-80s Latin America or 1990s East Asia. Or 1990s Russia. Or Turkey. Or Mexico. Money flows into the region rapidly, which then leads to spectacular rises in housing prices, stock prices and the financial sector which stands in the center. When it stops, it all comes crashing down.
The book lays out how the financial sector reacted to this newfound debt situation, low interest rates from Alan Greenspan and a flattening of the yield curve. All these situations were ones where the “search for yield” caused Wall Street to go to further lengths to pack in leverage in order to try and amplify profits. This all came crashing down when the music stopped, giving us the alphabet soup of Wall Street bailout programs that characterized 2008 financial policymaking.
The story about CDOs, subprime mortgages and TARP will be familiar to those who have read other books about the financial crash. This book is unique for putting the situation in a similar situation to England and Ireland, both countries that also increased their debts massively throughout the 200s and now have to deal with the consequences. Their solutions are also broader than most other treatments. Though they understand and acknowledge the need for larger short-term federal deficits to deal with the current weak economy, getting the long-term fiscal picture into health, through raising revenues and restraining spending, is front and center in their solutions. So are re-regulating the financial system to combat Too Big To Fail and keeping self-interested agents from hiding leverage to unsuspecting customers. In addition to this, increasing exports, a smaller trade deficit, reducing oil imports and dealing with China’s trade policies are also on their policy agenda.
Economic blogosphere readers will recognize Chinn as one of the brilliant masterminds of the must-read blog Econbrowser, and the rigor yet accessibility of the that blog is on display in this book. The book is capable of dealing with some of the most complicated economic arguments about the crisis in a way that is straightforward and capable of being understood by its audience.
And it is important to emphasis how much this is not on the radar of most discussions of the crisis. The crisis discussion usually creates stories out of the greed of the deregulated financial sector, the implicit and explicit goals of government, the Federal Reserve for a host of reasons, without even touching on the issues of international capital flows. That this book gets this topic onto the agenda makes it a worthwhile enterprise.
Here are some critical questions I have that I’ll use to kick off discussion of the book:
1. The general consensus among elite thinking is a neoclassical model where trade in goods shouldn’t be inhibited as self-interest will allocate resources to-and-from people and countries will take the best, comparable, advantage of them. This is the basis of international trade, and this presumably includes the international trade of capital that concerns you. Sometimes there’s a role for the government in handling externalities, like pollution, and public goods, like defense, but in general markets give us the best allocation possible.
How does your book work within and against this theory of how markets work?
2. A meta-metaphor for your book is that the United States went through an event like the East Asian crisis in the 1990s. But in that crisis, interest rates rose very steeply and exchange rate plummeted in the relevant countries. This forced the governments to curtail domestic expenditures – our favorite word “austerity” – causing even more havoc.
We are experiencing the opposite of that in the United States – the econoblogosphere has contests to see who can find the most creative way of describing to a general audience how low interest rates actually are (Karl Smith is winning with pointing out negative reals rates on 5-years). Has the current account deficit actually imposed a macroeconomic problem in the United States and are things like the East Asian crisis the best model?
3. How directly – what is the mechanism – did the current account balance cause the housing bubble? The most obvious mechanism is by driving down the interest rate. But wouldn’t the major benefit of cutting the Federal deficit during the 2000s have also been causing lower interest rates? And how much of the capital from countries we had an current account balance with went towards mortgage securitization, as opposed to treasuries?
4. Related to 3. Reading this book, I am tempted to think that the Federal deficit wasn’t large enough in the 2000s. There’s a story here that Wall Street had to create debt to meet the supply of credit (or the demands of international investors), and the only way to try and do that was try and alchemize gold out of junk. If the Federal deficit was larger, that debt could have substituted for the debt that became subprime mortgages, and presumably been put to better use (infrastructure, green energy, etc.). Indeed the big characteristics of the housing debt was that it was engineered to (look like it would) have similar risks and liquidity of Treasury debt – implying there wasn’t enough Treasury debt. Wouldn’t there just have been more CDOs if the Federal deficit was smaller in 2006?
5. Separately, what would have happened if East Asian countries couldn’t have accumulated reserves during the 2000s – could they have done counter-cyclical policies in the Great Recession? Indeed there’s an argument that reserves were a form of “self-insurance” by countries that were terrified of using the IMF as a provider of insurance against balance-of-payments shocks.
6. As opposed to most narratives on the crash, Wall Street doesn’t take on an incredibly important or interesting role in the generation of the housing bubble in your book. They aren’t greedy banksters finding ways to rig the game or noble John Galts pushed around by community organizers. They are largely middle-men, intermediaries in the battles of international capital flows. Indeed there’s a passivity to the financial sector, which increases in size and profitability roughly in line with the debt itself and benefits disproportionately since it can’t be traded offshore.
To use a blunt, but fun, analogy you do not, Wall Street functions sort of like drug dealers in this model. Drug dealers can be immoral and shady, yet they don’t fundamentally create the supply of drugs – that’s the result of factors in South America and Afghanistan and run by higher-ups like “The Greek” from the show The Wire – or the demand for drugs, which comes from consumers. They can be bad human beings but, unless you are a neocon drug warrior, attacking drug dealers can only make a temporary dent in the ultimate trade of drugs.
Two things to complicate that. (i) As I read your argument, it is at least partially predicated on the idea that the marginal unit of foreign capital that came into the United States couldn’t find productive uses – implying that the financial sector is a massive allocative failure. And (ii) there are many stories coming out about how Wall Street was able to create instruments simply to bet against them, stories like the hedge-fund Magnetar, which kept much of the securitization market working post 2005. Thoughts on these?
(Special thanks to JW Mason for discussion on these topics.)